Tuesday, June 6, 2017

Attractive Acquisition Attributes – Part Two, Recurring Revenue

I will be honest with you, I am not a big fan of Revenue when it comes to discussing business valuation.  Multiples of revenue are frequently used to determine business value but I generally dismiss them as misleading or meaningless.  I am a firm believer that business value is driven by earnings.  I am also a firm believer that consistency of earnings is a major factor in reducing business risk and therefore increasing value.

Even though I do not place a great deal of reliance on revenue valuation multiples, I must admit that revenue is where earnings start and therefore the consistency of revenue can be an important value driver.  The reliability of a recurring revenue model is the epitome of consistent revenue and therefore consistent earnings.  Given the choice, a buyer will be much more attracted to a business with a recurring revenue model than one that is not.  One of the biggest concerns business buyers have in an acquisition is customer retention.  Businesses that can demonstrate a high level of customer retention, lower the acquisition risk for the buyer and increase the value of their business.

Recurring revenue comes in many forms and some industries benefit from it naturally.  The most obvious of these are industries such as the utilities, cable & internet providers, cell phone companies, security alarm monitoring companies and other subscription based companies.  Even software developers and IT companies have created recurring revenue models with the software-as-a-service business model and the annual service contract.  Consumers of these services are frequently called subscribers.  When you can realistically call your customers subscribers, it is safe to say you have created a recurring revenue model.

So, what do you do if you are not in one of these industries and the sale of your product is not traditionally thought of as a recurring sale?  Sometimes it is simply a matter of rethinking what you do and how you do it; and at other times it may mean you need to expand your product offering to include a recurring revenue component. 

The software development industry is a great example of rethinking their product offering.  Traditionally, software development companies would package and sell their product for a single, fixed price.  Then that industry came up with the idea of selling a maintenance contract along with the software sale.  The monthly, quarterly or annual maintenance fee became the recurring revenue component.  Then they migrated to the software-as-a-service model where they bundled the software and the maintenance as a single product with a recurring periodic payment.

A good example of the type of company that might have to expand their product offering to create a recurring revenue stream is a manufacturer or distributor of capital goods.  In addition to the one-time (or let’s call it periodic) sale of the higher-priced capital goods these companies began to offer maintenance services or even service contracts.  I recently sold a distributor of capital goods that also offered inspection services to support the equipment they sold. 

Be creative, rethink and see if there is some way to add a recurring revenue component to your business.  Recurring revenue does not need to be 100% of your revenue stream but to the extent you can create some component of recurring revenue you will definitely increase the attractiveness of your company as an acquisition candidate. 

Alan D. Austin, CFA

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